Portfolio Diversification Is Key: Consider These ETFs

People try to diversify among different asset classes to provide portfolio protection during down times. However, this financial crisis disappointed many investors, because almost all assets went down together.

“Correlation” is how two securities move in relation to each other. It is a growing trend that assets are more correlated than before. According to CFA Institute Conference Proceedings Quarterly June 2009 issue, the correlation of MSCI EAFE (Europe/Australasia/Far East) index with the S&P 500 since 1970 is about 0.7; since 1990, it is more than 0.8. In other word, they are highly correlated.

In today’s uncertain markets, diversification is the key. After all, investors should not have all of his/her eggs in one basket. I ran the correlation between SPY and the top 100 ETFs (by net assets) since their inceptions . Daily ETF prices are from Yahoo Finance as of 07/17/09.

Below are some of them. As you can see, the correlation between SPY and EFA since its inception (which was around 9 years ago) is 0.96.

Most of the ETFs I picked have been in the market for more than 5 years (with the exception of SLV). Even bonds (AGG, TIP, TLE) are having positive correlations with SPY, though they are much lower than other equity ETFs.

As I highlighted in the table above, GLD has negative relationship with SPY. In other words, they tend to move in different directions.

According to Matt King, managing director of credit products strategy of Citigroup, we are looking for a 40% increase in government bond issuance in Europe in 2009 and a 140% increase in issuance in the US. Over 50% of US debt is held overseas, particularly by China and sovereign wealth funds. When they start to get concerned about future inflation eroding the value of their holdings, they might stop buying US bonds.

But when that happens is anybody’s guess.

Disclosure: I have long positions in EEM, EFA, SPY, TIP.

Comments

[DONE_SONZ:]

SPY and GLD can move up together.The market goes up,the dollar goes down.Thats you'r reflation trade.If the market crashes, and becomes the new trend,SPY down,GLD up.

Jul 19 08:19 AM

[GMiki1:]

I was going to say that: GLD and SPY can rise togerher. The dollar and gold can also be correlated--move up together--though they most often move in opposition.

Jul 19 11:26 AM

[Leif Peterson:]

GLD is based on gold, which is a commodity. The price of any commodity is based on what it can be sold for. For diversification, it would be better to construct a portfolio with less volatile index and currency ETFs, whose pairwise correlations range from -1 to 1. GLD and SPY price returns are quite volatile and driven by the combination of fear, emotion, market sentiment, corporate earnings, and economic reports.

Right now investors should be loading up on US equities, while preserving assets with 10-15% GLD (or gold mutual funds), 10-15% short-term treasuries(not cash reserves), 10-15% municipal bonds (e.g. PIMCO real return bond fund). Everything is pointing to devaluation of the dollar and inflation. The one currency that has done well over the subprime mortgage crisis (market crashes last Sept'08) is the Japanese Yen (FXY). You could also invest in some dollar bear ETFs [seekingalpha.com/artic...].

Jul 19 11:27 AM

[jambo:]

>
> Right now investors should be loading up on US equities, while

loading up on US equities?? Yep, just in time for the next very serious leg down! With "..equities" trading at roughly 132 times earnings using gaap buyers need to settle in for the next... I wanna say, lifetime?
Does the term pump monkey apply here?

Jul 20 06:46 PM

[Living4Divi...:]

Great article, Hao.

One caveat: Because correlations change over time, it is a bit like comparing apples and oranges when you compare a fund that started in 98 against a fund that started in 06. Still, you have no choice because that is when the funds started.

Question: from which website did you get your correlation data ??

Jul 21 10:25 AM

[Leif Peterson:]

>Right now investors should be loading up on US equities

The above refers to companies whose earnings have steadily increased over the last several years, increased during Sept-Oct '08, Q1, Q2 of this year, and have projected earnings growth. Why would anyone invest in companies with decreased earnings. Finding such companies involves work, and when done, the list won't include equities with large PE ratios.

Jul 21 04:41 PM

[ff4444:]

Useful article Hao. There is a web site where you can back test different portfolio asset allocations to the diversification benefits in action. I think it is a good thing to at least know how your portfolio would have performed in the past, even though the future is unknown.

www.riskcog.com

Jul 25 05:33 PM

[Hao Jin:]

I downloaded daily data for each ETFs from Yahoo Finance, and then calculated correlation data by myself, using Microsoft Excel only.

On Jul 21 10:25 AM Living4Dividends wrote:

> Great article, Hao.
>
> One caveat: Because correlations change over time, it is a bit like
> comparing apples and oranges when you compare a fund that started
> in 98 against a fund that started in 06. Still, you have no choice
> because that is when the funds started.
>
> Question: from which website did you get your correlation data ??

Aug 15 06:13 PM